1. Foreign Exchange Market Conducted BY: Mohammad Ramzan, CFA On Behalf of

2. Course Objectives Understanding theoretical background of exchange rates History of Foreign Exchange Market Market Place Exchange Rate Regimes Fundamental Factors Structure and mechanism of the Foreign Exchange Market Forward and Swap Rates Theory of Determination of Exchange Rate: PPP

3. Foreign Exchange International Trade –Do we need International Trade?

4. Gains from Specialization and International Trade

5. Gains from Specialization and Trade International trade leads to mutual gain because it allows each country to specialize more fully in the production of those things that it does best according to the law of comparative advantage. Trade permits each country to use more of its resources to produce those goods that it can produce at a relatively low cost. With trade, it will be possible for the trading partners to consume a bigger bundle of goods that would be impossible for them to produce and consume domestically.

6. Gains from Specialization, Trade POP FOOD SHIRTS USAO,9100 x 2 = O,9 100 x 1 = 100 JAPAN 50 25 x 3 = 75 25 x 9 = 225 ----------------- -------------- Total World Prod. 275 325 PRICES USA1 Food = 0.5 Shirt 1 Shirt = 2.0 Foods JAPAN1 Food = 3 Shirts 1 Shirt = 0.33 Food

7. Gains from Specialization, Trade POPFOOD SHIRTS USA O,9O,9 x 2 = 400 0 x 1 = 0 JAPAN 50 0 x 3 = 0 50 x 9 = 450 World Production400 450 Possibility of trade? US should export food to Japan Japan should export shirts to USA

8. United StatesJapan 150 300 450 375 225 75 Food (million units) Before Specialization and Trade Food (million units) Production possibilities, U.S. Production possibilities, Japan Clothing (million units) 100O,9300400 100 O,9 300 250 150 50 M 350 400 450 N US 1 J1J1 S R

9. United StatesJapan Food (million units) Consumption Possibilities with Trade Food (million units) Clothing (million units) Consumption possibilities of U.S. with trade 100O,9300400 100 O,9 300 M 250 150 50 US 1 N 350 400 450 O 150 300 450 375 225 75 J1J1 R 400 T Consumption possibilities of Japan with trade S 50

10. United States 100O,9300400 100 O,9 300 M Japan 150 300 450 S 250 150 50 375 225 75 US 1 J1J1 N Food (million units) R Consumption Possibilities with Trade Food (million units) 350 400 450 Clothing (million units) 400 O T J2J2 O,9 250 US 2 50

11. Foreign Exchange International Trade necessitates exchange of currencies Movement of Capital creates another source of supply and demand Definition: The price at which one currency is traded in exchange for another in FX market is the exchange rate between the two currencies.

12. Foreign Exchange: History Bretton Woods: 1944 - 1971 –Delegates from 45 Countries –Pegging of currencies with US Dollar –Margin of movement: 1% +/- Dollar as a reserve currency Dollar was convertible to gold (1/35 ounce) Frequent adjustments took place US ran a continuous Current A/c Deficit Vietnam War worsened the US situation Pressure for convertibility 1971: US Unilaterally abandoned the convertibility

13. Foreign Exchange: History Post Bretton Woods: Free float Some regional treaties EMU –European Monetary Unit –Currency pegs with 2.5% +/- –Some weak currencies were allowed 6% +/- –Frequent Adjustments 1992: George Soros humbles BOE out of EMU 1999: Euro created – Maastricht Treaty

14. Foreign Exchange Markets

15. Foreign Exchange Market US$ is the cornerstone of the foreign exchange market Exchange Rates are quoted against US$ US Worlds biggest economy Reserve currency status Safe Haven status Large amount of world trade in US$ Almost all commodities traded in US$

16. Factors that affect currency’s Value National inflation rates – Imports/Exports –Inflation also affects the purchasing power of the currency Changes in real interest rates – Debt securities Investment. Differences in economic performance (GDP) – Equity and real asset Investment. Current Changes in investment climate. Prospects of higher return but also low risk. (Political stability, Legal system, Fair taxation, Capital movement, stable prices policies, Law and Order, Judicial System)

17. Factors that affect currency’s Value Trade and Current A/c Balance GDP – Gross Domestic Product: Market Value of all good and services produced within a country during a specific period Why is GDP important? Higher GDP means higher value of the currency and vice versa

18. Real and Nominal GDP The term "real" means adjusted for inflation. Price indexes are used to adjust income and output data for the effects of inflation. –A price index measures the cost of purchasing a market basket (or “bundle”) of goods at a point in time relative to the cost of purchasing the identical market basket during an earlier reference (or base) period.

19. Real GDP 2 = Nominal GDP 2 * GDP Deflator 1 GDP Deflator 2 Using the GDP Deflator to Derive Real GDP Data on both money GDP and price changes are essential for meaningful comparisons of output between two time periods. The formula for converting the nominal GDP into real GDP is:

20. Source: U.S. Department of Commerce. 1996 2001 % increase Nominal GDP (billions of U.S. $) Real GDP (billions of 1996 $) $7,813 $10,208 30.7% Price index (GDP deflator, 1996 = 100) 100.0 109.4 9.4% $7,813 $9,331 19.4% Using the GDP Deflator to Derive Real GDP Between 1996 and 2001, nominal GDP increased by 30.7%. But, when the 2001 GDP is deflated to account for price increases, we see that real GDP increased by only 19.4%.

21. Government Policies An expansionary monetary policy will lead to a depreciation of the home currency. A restrictive monetary policy will lead to an appreciation of the home currency. A more restrictive fiscal policy should also slow down economic activity and inflation, and real Interest rates. Lower Inflation and Lower real Int. rates may have conflicting affect. A more expansionary fiscal policy has the reverse effect. Fiscal Policy is hard to judge.

22. Exercises

23. Exchange Quotes: Direct A direct exchange rate is the domestic price of foreign currency. Let “DC” be the domestic currency, and “FC” be the foreign currency. A direct quote could be represented as: For example: 0.5 DC = 1 FC 1.25DC = 1 FC

24. Indirect Foreign Exchange Quotes An indirect exchange rate is the amount of foreign currency equivalent to one unit of domestic currency. For example, 2 FC: 1 DC –Note this conveys the same information as our previous example. –For example: 0.0067 $/Yen would be an indirect quote in Japan.

25. Quote Conventions Internationally most currencies are quoted in terms of 1 US$ = ?. There are two main exceptions: –British pound (has always been quoted as dollar price of one pound). –Euro (convention adopted to quote the foreign currency value of one euro).

26. Quote Conventions Base Currency/Counter base (Quoted Currency) Check: www.imf.org/external/np/fin/rates/rms_rep.cfm Quotations are usually given with five digits. For example, USD/JPY 118.55 GBP/US$ 1.7725 1.77 = Big Fig; 25 = pips, points

27. Exercises Exercises on Quotes

28. Cross Rates A cross rate is the exchange rate between two countries inferred from each country’s exchange rate with a third country. For example, bank A gives the following quotations: $/CHF = 1.3110 – 20 $/JPY = 118.90 – 00 –Calculate the CHF/JPY rate: CHF/JPY bid rate = 118.90 and 1.3120 are relevant 1.3120CHF = 1 US$ = 118.90 118.90/1.3120 = 90.625 CHF/Yen ask rate =119.00/1.3110 = 90.770 Cross rate is: CHF/JPY = 90.625 – 90.770

29. Cross Rates GBP/USD: 1.8250-60 USD/JPY: 116.80-90 Calculate GBP/JPY? For Bid: 116.80 and 1.8250 are relevant –1 US$ = 116.80JPY –1GBP = 1.8250 US$ = 116.80 x 1.8250 = 213.16 For Offer: 116.90 and 1.8260 are relevant –1 US$ = 116.90 –1 GBP = 1.8260US$ = 1.8260 x 116.90

30. Cross Rates Rules of Thumb to remember: –If the rates of two currencies are quoted in same terms, the cross rates is really a X, i.e. bid to offer and offer to bid and it involves a division. –If the rates for two currencies are quoted in different terms, then the cross is a multiplication of bid to bid and offer to offer.

31. Exercises Exercises for cross rate calculation

32. Risks Risk of a long position: Price may go down –Profit of a long position: When price goes up Risk of a short position: Price may go up –Profit on a short position: When price goes down Market Risk Liquidity Risk Credit Risk Settlement Risk

33. Forward Rates Spot rates are quoted for immediate currency transactions (although in practice it takes place 48 hours later). Forward exchange rates are contracted today but with delivery and settlement in the future. In a forward, or futures, contract a commitment is irrevocably made on the transaction date, but delivery takes place later, on a date set in the contract.

34. Forward Premiums/discounts Base currency…$, Pound, Euro Formula: F = spot {1+(Int Rate of counter- base*days/conventional year)/1+(Int Rate of Base currency*days/ conventional year)} Use proper days’ convention

35. Forward Rates: Calculation GBP/US$ = 1.6400 - 10 Assuming one can borrow/lend at market rates (6 Months) Pound Interest Rate: 3.75 – 3.80% US$ Interest Rate: 1.15 – 1.20% P98,164.5 = $161,087.90 @ 1.6410 $161,087.90 @ 1.20% = $162,065.17 P98,164.5 @ 3.75% = P100,000 162065.17/100,000 = 1.62065

36. Forward Rates: Calculation Using the Formula 1.6410 * {1+(0.012*182/360)/1+(0.0375*182/365)} =1.6410 * (1.006067/1.018699) =1.6410 * 0.9876 =1.62065

37. Forward Rates: Calculation GBP/US$ = 1.6400 – 10 (Spread: 10 points, 0.061%) Assuming one can borrow/lend at market rates (6 Months) Pound Interest Rate: 3.75 – 3.80% US$ Interest Rate: 1.15 – 1.20% P98,140.44 = $160,950.32 $160,950.32 @ 1.15% = $161,886.07 P98,140.44 @ 3.80% = P100,000 161,886.07/100,000 = 1.61886

38. Forward Rates: Calculation Using Formula 1.6400 * {1+(0.0115*182/360)/1+(0.0380*182/365)} 1.6400 * 1.005814/1.01895 1.6400 * 0.9871 1.61886

39. Forward Spread Spot 1.6400 – 10 Forward1.6189 – 07 Spread in Spot 10 points Spread in forward18 points

40. Forward Premiums/discounts Spot 1.6400 – 10 Forward1.6189 – 07 Difference0.0211 -.0203 Also called Swap Points Is GBP at discount/Premium? Rule: Higher interest currency is always at discount in forward and lower interest currency always at premium

41. Swaps In inter-bank market, forwards are quoted as under: Spot GBP 1.6400-10 Swap 1-month 35 – 32 3-months 105 – 100 6-months 211 – 203 12-months 430 – 420

42. Swaps Revisited How to use swap points: If the bid is higher than offer of swap points, the base currency is at discount If the bid is lower than offer, the base currency is at premium

43. Swaps Revisited How to use swap points: If the bid is higher than offer of swap points, Deduct swap points from spot rate If the bid is lower than offer, Add swap points to spot rate

44. Swaps Revisited Make Outright forward rates Spot GBP 1.6400-10 Swap 1-month 35 – 32 3-months 105 – 100 6-months 211 – 203 12-months 430 – 420

45. Swaps Revisited Make Outright forward rates Spot CHF 1.2760-70 Swap 1-month 12 - 10 3-months 31 – 28 6-months 60 – 55 12-months 112 – 104

46. Forwards Revisited You can construct a forward (3-month) through spot market and swap market Spot GBP 1.6400 - 10 3-months swap 105 – 100 You want to buy GBP forward

47. Forwards Revisited You can buy spot first, let’s say 1 mio GBP at 1.6410 Then at 100 you sell/buy 1 mio pound Swap Transaction: You sell in spot and buy in forward Rates: Spot 1.6410 Forward1.6310

48. Arbitrage Arbitrage involves the simultaneous purchase of an undervalued asset or portfolio and sale of an overvalued but equivalent asset or portfolio, in order to obtain a risk free profit on the price differential. Arbitrage keeps exchange rates in line with each other and with risk free interest rates. –For example, the $/Euro rate must be the same, at a given instant, in Frankfurt, Paris and New York.

49. Various arbitrage opportunities to consider... With respect to the exchange rate between two countries, the rate in one country should be aligned with the rate in the other. If not, a bilateral arbitrage opportunity exists. A triangular arbitrage opportunity occurs if the quoted cross-rate between two currencies is higher or lower than the cross-rate implied by the exchange rates of the two currencies against a third currency.

50. Triangular Arbitrage Triangular arbitrage involves three steps: –Pick the cross-rate currency –Determine whether the cross-rate bid-ask quotes are in line with the direct quotes by determining whether it is cheaper to buy foreign currency directly or indirectly. –If the actual cross-rate quote is not in line with the quoted cross-rate quotes, an arbitrage opportunity exists.

51. Covered Interest Rate Arbitrage The process of simultaneously borrowing the domestic currency, transferring it into foreign currency at the spot exchange rate, lending it, and buying a forward exchange rate contract to repatriate the foreign currency into domestic currency at a known forward exchange rate. The net result of such an arbitrage should be nil.

52. Covered Interest Rate Arbitrage Spot rate = 1.6400 $/pound sterling 6-month Forward rate = 1.6072 $/pound sterling U.S. 6-m rate = 1.15% UK 6-m rate = 3.75% –Annualized forward discount = – 4.0% –Interest rate parity is violated. Dollar is stronger, pound weaker Borrow in £ for 6 months, Sell GBP for $, Invest $ for 6 months buy £ forward.

53. Forwards Exercises

54. Arbitrage on Swaps There is an active swap market in Karachi in $/PKR. There is restriction on free movement of capital – exchange control. Assume the fair $/PKR 6-m swap should be 95-100 (with spot at 60.25 it would mean fwd at 61.20/25) but for some reason swap comes down to 70-75 – by exporters or SBP b/s swap - (implying a fwd rate of 60.95/00). In a free market condition, arbitrageur should buy the cheap dollar in forward, sell dollars in spot by borrowing them for 6-months. Is it possible and assured? Can local banks can eliminate the inefficiency through arbitrage? Risk of further deterioration, loss on revaluation Can foreign banks come in and arbitrage?

55. Arbitrage on Swaps That anomaly leaves the swap misalignment in the market for considerable time, from where it could realign or get even worse. This creates a phenomenon where swap market functions like a separate financial product which has it own dynamics with swaps points moving up and down depending on swap/fwd demand and supply. However, over a medium term swap points should revert to their fair value. This creates interesting trades in swap market

56. Arbitrage on Swaps Some Trades in swap market –Arbitrage: Given sufficient resources Anticipate next move of the Exporters, Importers or SBP and front-run them. –E.g.you expect exporters to sell dolls in fwd, which will compress swap points, you can sell swap in anticipation (b/s 6 months) and unwind when swap points drop. You can gap-trade the swap. E.g, swap points came down to 60-65, you can sell/buy at 65 for 6 months and immediately b/s for 1 week.

57. Exercises

58. Purchasing Power Parity (PPP) Relation PPP states that the spot exchange rate adjusts perfectly to Price differentials between two countries. Law of one price. There are two versions of PPP: –Absolute PPP This claims that the exchange rate should be equal to the ratio of the average price levels in the two economies. –Relative PPP

59. Purchasing Power Parity (PPP) Relation Relative PPP –This claims that the percentage movement of the exchange rate should be equal to the inflation differential between the two economies The PPP relation is presented as: Exact S 1 /S 0 = (1 + I FC )/(1 + I DC )

60. Thank you!!